How to Use TIPS to Calculate Inflation Expectations
Using the Treasury Inflation-Protected Securities Formula
Investors can use Treasury Inflation-Protected Securities (TIPS) to calculate inflation expectations using some simple math, but with a caveat—the result does not provide an exact measure.
What Are TIPS?
Treasury Inflation-Protected Securities are Treasury notes whose principal increases with inflation and decreases with deflation. The securities' value adjusts following the non-seasonally adjusted Consumer Price Index, which is the most common inflation measurement.
Like a plain-vanilla Treasury note, TIPS provide investors with a fixed-rate semi-annual interest payment. The interest payment is calculated using the adjusted value of the bond.
This payment increases with inflation, but it would decrease in the rare case of deflation (i.e., falling prices with an increase in currency purchasing power). The amount of principal an investor receives is the original investment adjusted for inflation. In short, the principal rises or falls with the CPI, while the coupon rate represents the investor’s “real return,” or return above inflation.
TIPS can trade with a negative yield. This has happened on several occasions when the Federal Reserve has kept its policy rate low.
In comparison, plain-vanilla Treasuries carry no such inflation protection. Since a Treasuries investor is fully exposed to the impact of inflation on the underlying bond, they demand a premium, or a higher interest rate, which could be considered a protection against inflation.
Calculating Inflation Expectations with TIPS
Investors calculate risk premium by comparing the difference in yields on a Treasury and a Treasury Inflation-Protected Security (TIPS) with similar maturities. The result indicates the amount of inflation protection investors should need by representing expected inflation.
For example, if the five-year Treasury has a yield of 3% and the five-year TIPS has a yield of 1%, then inflation expectations for the next five years are roughly 2% per year. Similarly, using two- or ten-year issues would calculate the expectation for those periods. This difference is often referred to as the “break-even” inflation rate.
The formula for the break-even inflation rate is:
If an investor is curious about what Treasury yields might look like in the future given an expected inflation rate, they could rearrange the formula:
The same could apply if they are curious about TIPS yields with a given break-even inflation rate:
Using this method, investors can easily find the market’s expectation for the future inflation rate, at least in theory. The idea of a break-even inflation rate is only a theory because the differences between the two securities lead to market distortions that prevent this calculation from providing an exact result.
Factors That Influence Expected Inflation
TIPS’ trading volume is much lower than that of Treasuries, so the yield differential can often change due to technical factors unrelated to inflation expectations.
One of the most significant factors that influence the price of nominal and real yield securities is inflation expectation by investors, which leads to the premiums they are willing to pay for either type of investment.
For example, if investors calculate the break-even inflation rate for 5-year maturities to be 1.8% and expect inflation to stay at the Federal Reserve's target rate of 2%, they would buy TIPS. If the break-even rate were higher than anticipated inflation, they would buy nominal Treasuries.
When investors try to beat inflation, they create movements in prices and interest rates due to the fluctuations in demand they induce—which could negate their attempts to mitigate the risk of inflation.
Studies also indicate that expected inflation estimates are too high. Different approaches are under consideration, such as correcting for liquidity with estimates that take it into account. Break-even inflation is therefore not a reliable method of forecasting future inflation rates, but remains another tool in an investor's toolbox for estimating risk and reward.
ETFs That Track Break-Even Inflation
There aren't many funds or investment types that track or use the break-even rate. However, the ProShares Inflation Expectations ETF (RINF) tracks the TIPS-Treasury spread with no leverage. The share price of this fund should rise when expectations go up. Investors can trade inflation expectations since this exchange-traded fund tracks the gap between 10-year Treasuries and 10-year TIPS.